Rules For Post-Recession Investing

Despite the pundits' pronouncements of green-shoots or signs that the economy is on the mend, many investors remain scarred and understandably sensitive to the previously unimagined threats to capital market stability. In many cases, not only have they reduced their equity exposure to levels that will not help them beat inflation, many have pulled out of the publicly-traded markets entirely, and remain on the sidelines.

Return to InvestingIf you are planning to retire on the assets you have accumulated or are accumulating, you need to get exposure to the equities markets and you need to do that sooner rather than later. Global equities markets work and you deserve your share of the positive long-term returns they generate.

Generally, market declines cause panic, to quote a study by DALBAR - a leading developer of measurement systems for intangibles, such as customer behaviors, in the financial services industry. A 2003 study by DALBAR found "motivated by fear and greed, investors pour money into equity funds on market upswings and are quick to sell on downturns." The report goes on to say that in the past 19 years, the average equity investor has earned 2.57% annually compared to 12.22% for the S&P 500 Index. This study clearly illustrates the "reactive" nature of today's investors and just how much it costs them in return. It's important to recognize how much emotions influence investing decisions most often to investors' detriment.

Keys to Excellent ReturnsAs investors slowly emerge from their fear-induced stupor, it is important to review important principles which have provided excellent risk and inflation-adjusted returns over the last 50 or more years. With these foundational principles in place, the investor will be ready to participate in the global capital markets.

Don't Forget About Your Risk ToleranceReturn statistics are perhaps the most quoted numbers in personal finance and investing. Quantitative measures of risk or volatility are undoubtedly the least quoted. When you look at your risk tolerance, consider three factors: capacity to take investment risk, need to take investment risk and desire to take investment risk. There are many questionnaires and other tools online that attempt to help investors measure these variables. Use them as a sanity check for your own measures given your previous investment experiences.

Draft and Sign an Investment Policy Statement (IPS)Institutional investors, like pension funds and university endowments, have a document which defines the types of investments allowed in their portfolios. Good fiduciary investment managers have an IPS for each of their clients. An IPS takes all the relevant inputs and creates your own personal investment plan and diversified asset allocation. Essentially, the IPS helps you stick to the plan and tells you what to do when in doubt.

Keep The Investment Decisions SimpleWith an IPS in hand, you now have specific marching orders to populate your portfolio with actual securities. Index mutual funds and exchange-traded funds (ETFs) reduce costs and provide broad exposure to specific asset classes. To my knowledge, no one has been able to "beat the market" year in and year out, so active investment management is not a reasonable option. Keep costs low and stay invested. That is how the race is won and your goals are achieved.

These are foundational steps in the construction of your portfolio. The next question is, "How should you get back in?" This question essentially refers to the two primary options: put it all in at once or stage the money in over time. Which is best?

All at OnceFor investors who have just experienced one of history's most challenging economic periods, this option must seem the least interesting. However, in a world where market timing does not add additional return and where the expected returns are positive, it makes the most sense. Any averaging-in strategy will keep money out of a rising market. Nevertheless, averaging techniques remain very popular in the financial press and in practice. The reason for this is primarily because it feels good.

Averaging Into the Market Over TimeIf you accept that you need exposure to the equity markets, there is a high probability that you will consider averaging into the market versus making a lump sum investment. Given that likelihood, what is the best way to average into the market? Quite simply, it depends on larger financial planning concerns like your need for cash and outstanding obligations. Beyond that, the options are innumerable: contribute a set amount; a set percentage of the remaining balance; a fixed dollar amount; a variable amount based on fluctuations in the market; a variable amount on a random schedule and on, and on. Here are a few important considerations as you consider your strategy:

Formalize the plan by writing it down.

Be careful of executing too many trades thereby incurring very high transaction costs. The research overwhelmingly states that the benefits are marginal at best and most likely are negative, so don't erase the emotional benefit by piling on hundred or thousands of dollars of trading fees. No-transaction fee mutual funds can be beneficial in this area.

Be careful of dollar-cost averaging up. If the market is rising, you will be buying higher and higher levels. Remember, the market has had, and we expect that it will continue to have, a positive bias as global economies continue to rise. If you divide your investment into too many pieces, you will end up investing the money over an ever longer period of time and therefore increasing the probability of dollar-cost averaging up.

Try to divide the investments among the least correlated assets. For example if you are going to invest $10,000 into five different investments, try to pick U.S. large cap, international large cap, commodities, real estate and maybe fixed income.

ConclusionNo one really knows when it is "safe" to get back into the markets, or whether the market is experiencing a dead cat bounce, sucker rally, V-shaped recovery or W-shaped recovery. You will not receive an email, phone call or other advance notice saying, "Now is the time!" More than likely, when the news is rosy and you start feeling safe about getting back in, you will have done irreparable damage to your ability to keep pace with the market. Do your best to keep emotions out of your investments and jump in.